Of Liberals and Loopholes

The current tax code favors high-tax states.

Updated Dec. 18, 2012 12:01 a.m. ET

One post-election budget surprise has been President Obama's resistance to
John Boehner
's
proposal to get $800 billion in new revenue by closing tax loopholes. Here's one likely reason: the high tax rates of his blue-state Democratic brethren.

One of Mr. Boehner's ideas, taking a cue from Mitt Romney, would impose a limit on annual deductions. During the campaign Mr. Romney suggested a range for a deduction cap, anywhere from $17,000 to $50,000 a year, and many liberal pundits praised the idea on equity grounds.

ENLARGE

Since the affluent tend to itemize their deductions more than do average taxpayers, and since the affluent pay higher marginal tax rates, they tend to benefit more from deductions. Ergo, limit deductions and you raise the effective tax rate (not the marginal rate) of the affluent. (The effective tax rate is the share of total income paid in taxes, while the marginal rate is the tax on the next dollar earned.) Such a reform would help tax efficiency and equity, and the economy would benefit from fewer investment distortions.

But suddenly liberals are having second thoughts, and our guess is that this is because residents of high-tax Democratic-run states are about twice as likely to take advantage of tax loopholes as taxpayers in low-tax states. For example, 44% of Connecticut filers itemize their deductions, but only some 21% of North and South Dakota residents do.

One tax writeoff in particular illustrates the point: the deduction for state and local income taxes. This allows a high-income tax filer who pays, say, $20,000 in state and local income taxes to deduct those payments from his federal taxable income.

Because the highest federal tax rate is 35%, the value of the state and local deduction is enormous for high-tax states. If President Obama succeeds in raising the federal tax rate to 39.6%, the value of those deductions rises to nearly 40 cents on the dollar. This deduction certainly eases the pain of New Jersey's 8.97% top tax rate, or Hawaii's 11%.

One pernicious effect, however, is to favor high-tax states at the expense of the nine states with no income tax and those with low rates. That's clear from looking at the IRS tax return data for the 50 states and the District of Columbia. In 2010, the deduction for state and local income taxes for all states amounted to $249.7 billion.

But here's the blue-state kicker: $51 billion of those writeoffs were claimed by residents of one state, California. And five liberal states—California, New York, New Jersey, Maryland and Massachusetts—accounted for about $121.8 billion. A mere five states accounted for nearly half the federal revenue lost from this tax deduction.

The inequity is especially stark if we compare this to states without an income tax. The average state and local income-tax deduction claimed per tax return in 2010 was $4,109 in New York and $3,819 in Connecticut. But the average Texan claimed only about $100, and the average Florida deduction was a mere $219. No wonder New York Senator Chuck Schumer opposes tax reform.

Residents of states without an income tax can also deduct some of their sales tax payments. But in 2010 those deductions only reduced taxable income for individuals in all states by $17.9 billion, and in Texas by $4.3 billion and Tennessee a mere $1.2 billion. State and local property taxes are also deductible from federal income tax, and those also tend to be higher in high-tax states. The nearby table illustrates how much more residents of high-tax states benefit overall from the state and local tax loophole.

We believe in federalism, and if affluent liberals want to pay 13.3% of their income to live in San Francisco, that's their foolish privilege. But it becomes everyone's problem if some of that tax burden is effectively borne by residents of Knoxville, Lubbock and Orlando because of the federal tax deduction.

To put it another way, when Californians voted to raise their top rate to 13.3% last month, they were voting to reduce revenue for the federal Treasury and thus increase the political pressure to raise tax rates on all Americans. The state and local tax loophole helps disperse and disguise the real cost of big government. As Mr. Obama likes to say, this is reverse Robin Hood.

All of which helps to explain what appears to be the ebbing liberal support for a tax reform that reduces rates in return for fewer deductions. Democrats in Congress once supported that kind of reform. But these days they tend to represent states with ever-higher tax rates that prop up state and local governments dominated by public unions that demand ever-higher pay and benefits. The resulting state tax burden would be intolerable if much of it weren't passed off on Uncle Sam.

Mr. Obama wants to raise tax rates, rather than eliminate deductions, so his fellow Democrats can keep raising state and local taxes without bearing the full economic and political cost. Tax equity and economic growth are the big losers.

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